The Blog of HORAN Capital Advisors

Sunday, August 02, 2015

For most of the market advance since the end of the financial crisis, low quality stocks have been the driver of equity returns. One factor that historically leads to outperformance for high quality stocks is increased market volatility. This higher volatility has certainly been absent for nearly four years and is evidenced by the lack of a 10% market correction since October 2011 and a low VIX level.

From a sector performance perspective, health care continues to lead the other market sectors over the one year and year-to-date time period. The laggards continue to be materials and industrials. These two sectors have been negatively impacted by the continued strength of the U.S. Dollar and weakness in the emerging markets.

The lack of strength in some of the cyclical sectors (materials and industrials) is partially attributable to the slow growth economy in the U.S., the strong dollar and weakness in emerging markets. Last week's GDP report continues to indicate below trend economic growth in the U.S. and a widening gap between actual and trend GDP growth. As the below chart shows, real economic growth since the end of the financial crisis has been half of the growth rate that was generated from 1950 through March 2009.

This slower pace of economic growth seems to have led some investors to gravitate to the more riskier segments of the market in light of overall lower market volatility. This has pushed equity valuations to slightly above average levels and has resulted in less margin of error for some of these growthier firms.

Thursday, July 30, 2015

Today's Sentiment Survey report by the American Association of Individual Investors shows bullish individual investor sentiment fell a steep 11.44 percentage points to a low 21.1%. The bull/bear spread is now -19.6%. The last time the bull/bear spread was at this level was the early part of 2013. For investors, this contrarian indicator suggests the market could be setting itself up for a move higher after trading sideways for the better part of this year.

Monday, July 27, 2015

I have noted in several earlier posts over the years the importance investment professionals place on the equity risk premium (ERP). Although the ERP is one important factor to evaluate, there is quite a bit of disagreement on on how to appropriately calculate the premium. In short though, the ERP is the additional return above the risk free asset an investor requires to invest in stocks. For example, if an investor has a view that the market is under valued and likely to go higher, then one's view is the ERP will decline in the future. Conversely, if the investor has a view that the market is over valued and likely to go lower, then the investor believes the ERP will increase in the future. As the below chart shows, the ERP has declined significantly since late 2011 in conjunction with strong stock returns since the end of the financial crisis

Because the Fed in the U.S. and central banks around the globe have pushed interest rates down to artificially low levels, this has caused investors' required absolute return on stocks to decline.

On Wednesday, the FOMC meeting announcement will take place around 2:00 p.m. There remains disagreement on when the Fed will raise short term rates, but if short term interest rates rise and cause a commensurate increase on the long end of the interest rate curve, this could place downward pressure on stock prices as the ERP is shifted lower. What can offset this narrowing of the ERP is strength in corporate earnings. However, earnings in Q2 2015 are estimated to decline around 3-4%. On the positive side, earnings comparisons are expected to improve in Q4 2015 and Q1 2016. This improvement in earnings growth is a result of companies lapping the headwinds from energy and the strong U.S. Dollar.

As the below charts show, in the short term, equity prices tend to decline at the onset of a rate hike by the Fed; however, the market tends to adjust and equities move higher over the rising rate cycle. We discussed this in a post early in 2014 titled, Rising Interest Rates Can Be Good For Stocks.

For investors interested in a more in depth review of the ERP, Aswath Damodaran, a professor at Stern School of Business at New York University, publishes a frequently updated paper on the various methods utilized in calculating the ERP.

At this point in time, if investors believe the Fed is very near starting to increase interest rates, stocks that could be impacted the most are the higher valuation equities and momentum stocks. It is these two types of equities that have attracted the most investor attention this year.

In July, Confidence in Federal Economic Policies did increase three points to 44.2, but remains below the neutral 50% level. The TIPP Index is comprised of three components.

The Six-Month Economic Outlook: a measure of how consumers feel about the economy’s prospects in the next six months.

The Personal Financial Outlook: a measure of how Americans feel about their own finances in the next six months.

Confidence in Federal Economic Policies: a proprietary IBD/TIPP measure of views on how government economic policies are working.

The weakness seen in this sentiment measure has carried over into other sentiment reports. The University of Michigan Consumer Sentiment Index reading, reported a week ago, fell to 93.3 versus the prior reading of 96.1. Econoday notes, "consumer sentiment has been running very strong most of this year and often well ahead of consumer spending readings which have been flat. But today's report (July 17th) suggests that the best for confidence may already have passed (emphasis added.)

The consumer sector seems to be more discerning in its spending resulting in a decline in the change in personal consumption expenditures and a commensurate increase in the savings rate (purple line in second chart below.)

A result of what seems like a pullback in consumer spending is business and retail inventory to sales ratios continue to increase. Some of this build is a result of an inventory build following the disruptive issues in the first quarter. However, with a slowdown in consumer spending and potential slowing in inventory build in the economy, these two factors will have negative implications for GDP growth in the second quarter.

Lastly, earnings reports for Q2 have, so far, exceeded analyst lowered expectations. Thomson Reuters notes through July 24th, 77% of companies have reported positive EPS surprises; however, only 52% have beat on revenue. The consumer seems to have weakened through the second quarter. With the consumer accounting for about 70% of economic activity, a more positive consumer will be needed to provide economic strength in the second half of the year. Oil prices seem to be taking another leg down with many commodities following suit. These lower energy prices should begin to show up in lower gasoline prices as well and may be necessary to stimulate consumer confidence and consumer spending.

Friday, July 24, 2015

Since February the S&P 500 Index has essentially traded sideways within a 4.8% trading range. This sideways market movement may be resulting in a trading pattern where the market is correcting over time versus correcting with a steep price drop. A sideways market correction enables earnings to catch up to the market's price. As the below chart shows, several of the technical indicators suggest the future market direction is one where the price could trade to the bottom of this trading range highlighted by the yellow box on the chart.

A closer view of the market, as provided by Charles Kirk of the The Kirk Report, shows there are three additional gaps the market may attempt to fill that will take the index level to the lower end of this trading range. His commentary included with his technical analysis notes,

"As shown in the chart [below], the S&P filled the first lower gap, tested and bounced from the 38.2 fibo, and then closed right at first support at the 50 day at S&P 2102. This is seen by many as an important support level that if not defended will soon bring the three other lower gaps into play as trade to targets."

One question is what factors will cause the market to trade to the upside and out of this trading range? One fundamental factor is that of company earnings growth. Recent earnings reports have generally beat analyst expectations, yet S&P 500 earnings growth for Q2 is expected to decline about 2%. Top line revenue results have been weaker than expectations in Q2, with companies citing headwinds from the stronger US Dollar. A positive is the energy and currency headwinds will begin to subside in Q3 and especially in Q4 and Q1 of 2016 as these headwinds are lapped in the year over year comparisons. In Q4 2015 and Q1 2016 earnings growth is expected to be about 4% and 9%, respectively. This better earnings growth could be a catalyst for higher equity prices beginning later in Q3 and into 2016.

Thursday, July 23, 2015

An interesting facet of the American Associations of Individual Investors Sentiment Survey has been the recent long streak of an above 40% reading for the neutral sentiment category. This week represents a record 16th straight week with the neutral reading above 40%. Although the neutral reading remains high, this week it did fall from last week's 45.95% to 41.87%. More of these neutral investors have now become more bearish as the bearish sentiment reading increased 2.36 percentage points to 25.60%, whereas the bullish sentiment reading increased a lesser 1.73 percentage points to 32.54%.

As the below chart shows, bullish sentiments remains at a relatively low level, near 1 standard deviation below its long run average. Additionally, the second chart below shows the 8-period moving average of the bullish sentiment reading and it remains near its lowest level since the end of the financial crisis six years ago.

Wednesday, July 22, 2015

In our recently published Summer 2015 Investor Letter we highlight issues impacting the market in the first half of the year. In the second quarter the world was not short of market influencing events as Greece, China and Puerto Rico all dominated the headlines. The second quarter proved to be another challenging quarter partially due to these events and volatility erased much of the year’s gains. However, U.S. economic data was certainly a bright spot as positive reports provide some optimism as we enter the second half of 2015. Beginning in the third quarter, the headwind resulting from the strong US Dollar and energy weakness should begin to subside and make year over year comparisons more normalized.

Also, we welcomed two new employees to our investment team in the quarter:

Senior Portfolio Manager, Todd Poellein, CFA

Todd joins HORAN Capital Advisors with over 10 years of portfolio management experience and nearly 20 years of industry experience. Todd graduated from the Kelly School of Business at Indiana University and spent a number of years at PricewaterhouseCoopers and Fifth Third Bank. He holds the Chartered Financial Analyst (CFA) designation and will bring great value to our client relationships with his knowledge of portfolio construction, security analysis and long-term planning.

Investment Associate, Matthew Woebkenberg

Matt is a recent graduate of the University of Notre Dame where he carried high honors while majoring in Finance and Spanish. Matt is already pursuing his CFA designation and will take Level I this December. Matt will support the portfolio managers at HORAN Capital Advisors and we look forward to his contributions.

For additional insight into our views for the market and economy, one can read our Investor Letter accessible at the below link.

Monday, July 20, 2015

Recent market commentary has highlighted the weak market breadth in spite of the equity market's continued move higher. Weak market breadth refers to the technical situation where more equity issues are declining than rising. This weakness raises a red flag in an environment where breadth is negative and the equity market continues to move higher. Below are a couple of charts and article links noting the weakness and subsequent returns when this occurred in the past.

Certainly, the breadth technical picture is something investors should continue to evaluate. However, what is equally, if not more important, are company fundamentals and the valuation level of the overall market. Below are a couple of charts on two market sectors that have attracted a lot of investor attention this year.

The first chart compares the S&P GICS Technology Sector to the forward P/E for the 67 companies that currently make up the sector. As can be seen from the chart, valuations are no where near the sector valuation reach prior to the tech bubble bursting in 2000. In 2000 the PE reached nearly 50 for the sector where today the sector is trading at a PE multiple of just under 15 times earnings.

Another sector that continues to attract investor interest is biotechnology. As the below chart for this sector shows, the biotech index (8 companies) has risen significantly since 2012. In spite of this sustained move higher, the sector PE is just over 17, far below the 2000 peak of 63.

Lastly, even the broader S&P 500 Index itself is not trading at the technology bubble level reached in 2000. The current forward PE is 17 versus the 2000 peak of 24. The current PE is just slightly above its long term average.

The weak market breadth is a variable investors might want to track, keeping in mind market valuations are far below the levels reached in early 2000. A critical variable will be corporate earnings looking out for the next four quarters. Companies have begun reporting their second quarter results (60 companies reported through 7/17). Earnings growth for the next four quarters is projected to back-end loaded. Thomson Reuters I/B/E/S is estimating Q2 2015 through Q1 2016 quarterly earnings growth will equal: -2%, -1%, 4% and 9%.

And finally, just a brief comment on individual investor sentiment, which we also review in our just completed Summer Investor Letter. AAII individual investor bullish sentiment was reported at 30.8% last week, which is nearly one standard deviation below the average bullish sentiment level. Two weeks ago the bullish sentiment reading fell to a low 22.6%. This low level of bullishness reported by individual investors is a contrarian indicator. Could the market be positioning itself for a rally to finish off the summer? Ryan Detrick wrote an article today, Investor Sentiment: Why A Market Correction May Be Slipping Away, that provides a good analysis of other sentiment indicators and what these indicators might suggest for market performance in the coming months.

Tuesday, July 14, 2015

The Twitter (TWTR) buyout offer hoax this morning have some believing this is an indication the market is trading at an overbought level. The thinking is investors are taking trading positions based on rumors versus evaluating company facts and company fundamentals. Mark Hulbert, a senior columnist at MarketWatch and the editor of the Hulbert Financial Digest, published an article late this afternoon, Why the Twitter Hoax Suggests the Market is Near a Top.

In the article he notes, " ...investors are increasingly resorting to betting on rumors as they become unable to find stocks that represent genuine long-term value." Mark Hulbert may certainly be right in noting the market is at a top; however, and equally or more important is the analysis of specific stock and market fundamentals. Broadly, from a market perspective, the valuation or price earnings ratio (P/E) of the market, does not seem indicative of an extremely overvalued market. The excellent J.P. Morgan Guide to the Market, contains a P/E chart for the S&P 500 Index that shows the forward S&P 500 P/E is just above the long term average P/E going back to 1990. Other valuation measures detailed in the below chart also are not indicative of an extremely overvalued equity market. For sure though, the easy money seems to have been made since the end of the financial crisis over five years ago, in the U.S. anyway.

Other technical market indicators also seem to indicate the market is, at a minimum, in a short term oversold level and beginning to move to a higher level. As can be seen in the below chart, the S&P 500 Index has found support at its 200 day moving average and is beginning to move higher over the last three days. Also, the MACD and stochastic indicators have turned positive from oversold levels as well.

Lastly, the percentage of S&P 500 stocks trading above their 50 and 200 day moving averages recently reached levels indicative of a short term oversold market and are now moving to higher levels as the S&P 500 moves higher too.

In investing nothing is a certainty; however, the potential resolution (kick the can) of the Greece situation seems to have eased some of the near term anxiety of investors for the time being. As second quarter earnings season unfolds, a potemntially clearer picture on the business environment will be forthcoming.

Thursday, July 02, 2015

The American Association of Individual Investor's sentiment survey release this morning shows bullish sentiment fell nearly thirteen percentage points to 22.6% The previous week bulls switched to the bearish camp with bearish sentiment increasing 13.4%. The bull/bear spread is now -12.5%. As a reminder, this contrarian sentiment measure can be volatile from week to week and is most predictive at its extremes.

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